The Fed can fight inflation, but it can come at a cost

One of the main reasons why Federal Reserve officials are not currently afraid of inflation is the belief that they have tools to deploy if it becomes a problem.

These tools, however, have a cost and can be fatal to the types of periods of economic growth that the United States is experiencing.

Raising interest rates is the most common way for the Fed to control inflation. It is not the only weapon in the central bank’s arsenal, with adjustments in asset purchases and strong policy guidance also at its disposal, but it is the most potent.

It is also a very effective way to stop a growing economy on its tracks.

The late Rudi Dornbusch, a noted MIT economist, once said that none of the expansions in the second half of the 20th century “died in old age. All were murdered by the Federal Reserve.”

In the early part of the 21st century, concerns are mounting that the central bank may become the culprit again, especially if the Fed’s easy policy approach stimulates the kind of inflation that may force it to brake abruptly in the future.

“The Fed made it clear this week that it still has no plans to raise interest rates in the next three years. But this is apparently based on the belief that stronger economic growth in almost 40 years will generate almost no lasting inflationary pressure, which we suspect is a view that will prove wrong, “said Andrew Hunter, senior economist at Capital Economics, in a note on Friday.

As it promised to keep short-term loan rates anchored close to zero and its monthly bond purchases buzzing at a minimum of $ 120 billion a month, the Fed also increased its outlook for gross domestic product to 2021 to 6.5%, that would be the highest annual growth rate since 1984.

The Fed also raised its inflation forecast to 2.2% still mundane, but above what the economy has seen since the central bank started to set a specific rate target a decade ago.

Most economists and market experts think the Fed’s bet on low inflation is safe – for now.

A litany of factors is keeping inflation under control. Among them are the inherently disinflationary pressures of a technology-driven economy, a labor market that continues to see nearly 10 million Americans employed less than a decade ago, and demographic trends that suggest a long-term limit to productivity and productivity. price pressures.

“These are very powerful forces and I bet they win,” said Jim Paulsen, chief investment strategist at Leuthold Group. “It may work, but it is a risk, because if it doesn’t work and inflation continues, the big question is: what are you going to do to close it. You say you have a policy. What exactly is this going to be?”

Inflationary forces are very powerful in their own right.

An economy that the Atlanta Fed is planning to grow 5.7% in the first quarter has just received a $ 1.9 trillion stimulus from Congress.

Another package may arrive later this year in the form of an infrastructure account that Goldman Sachs estimates may reach $ 4 trillion. Combine that with everything the Fed is doing, in addition to substantial global supply chain problems, causing a shortage of some goods and becoming a recipe for inflation that, although delayed, can still weigh in 2022 and beyond.

The scariest example of what happens when the Fed needs to intervene to contain inflation comes from the 1980s.

Rampant inflation started in the United States in the mid-1970s, with the rate of consumer price increases reaching 13.5% in 1980. Fed then-president Paul Volcker was tasked with taming the beast of inflation, and the he did, through a series of interest rates, increases that dragged the economy into a recession and made him one of America’s most unpopular public figures.

It is clear that the United States did very well on the other side, with a powerful growth spurt that lasted from the end of -1982 until the decade.

But the dynamics of the current scenario, in which the economic damage of the Covid-19 pandemic was most acutely felt by low-income people and minorities, makes this dance with inflation especially dangerous.

“If you have to abort this recovery prematurely because we are going to have an automatic halt, we will end up hurting most people that these policies have been approved to help more,” said Paulsen. “It will be these same low-skilled and less-qualified private areas that will be hit the hardest in the next recession.”

The bond market gave warning signs of possible inflation during much of 2021. Treasury yields, especially in the longer term, have risen to pre-pandemic levels.

That action, in turn, raised the question of whether the Fed could again become a victim of its own forecast errors. The Fed, led by Jerome Powell, has already had to backtrack twice on widespread statements about long-term policy intentions.

In late 2018, Powell’s statements that the Fed would continue to raise rates and shrink its balance sheet with no end in sight were met with a sale that made history on Christmas Eve. In late 2019, Powell said the Fed had finished cutting rates in the foreseeable future, only to have to pull back a few months later, when the Covid crisis hit.

“What will happen if the economic recovery is more robust than even the Fed’s revised projections?” said Quincy Krosby, chief market strategist at Prudential Financial. “The question for the market is always: is everything really temporary? ‘”

Krosby compared the Powell Fed to Alan Greenspan’s version. Greenspan led the United States during the “Great Moderation” of the 1990s and became known as “The Maestro”. However, that reputation was tarnished in the following decade, when the excesses of the subprime mortgage boom triggered a wild risk taking on Wall Street that led to the Great Recession.

Powell is staking his reputation on a firm position that the Fed will not raise rates until inflation rises at least over 2% and the economy reaches full and inclusive employment, and will not use a timetable for when to tighten.

“They called Alan Greenspan ‘The Maestro’ until he wasn’t,” said Krosby. Powell “is saying that there is no timetable. The market is saying that it does not believe”.

Certainly, the market has already gone through what Krosby described as “storms”. Bond investors can be fickle, and if they find that rates are rising, they will sell first and ask questions later.

Michael Hartnett, the chief market strategist at Bank of America, pointed to a number of other bond market shakes over the decades, with only the 1987 episode in the weeks before the 19 Black Monday stock market crash. October having “major negative side effects”.

He also doesn’t expect 2021 sales to have a big impact, although he warns that things could change when the Fed finally pivots.

“Majority [selloffs] are associated with a strong economy and Fed rate hikes or were they a recovery after a recession, “wrote Hartnett.” These episodes highlight the low risks today, but increase the risks when the Fed finally capitulates and starts to rise. “

Hartnett added that the market must trust Powell when he says the policy is suspended.

“The economic recovery today is still in its early stages and problematic inflation will still take at least a year,” he said. “The Fed is nowhere near increasing rates.”